A Surprise Tax From Life Insurance Loans

 

For some reason, the taxability of life insurance seems to be an old reliable in tax controversy.

Granted, there are areas involving life insurance that are not intuitive. The taxation of a split-dollar life insurance policy to an employee can be a bit puzzling until you have studied it one or ten times. There is also the tax history of “janitors insurance,” which resulted in yet another tax acronym (“EOLI”), the creation of Form 8925, and the recurring question “what is the purpose of this form” from young tax accountants ever since.

 

No, what we are talking about is the income taxation of vanilla-ice cream-on-a-regular-cone life insurance. Life insurance is normally nontaxable. You can change that answer by not ordering vanilla.

David and Cindy Fugler bought permanent (that is, cash value) life insurance on their two children in 1987. There was the initial year payment, plus additional yearly premiums, some of which were paid by borrowing against the policies. After many years, they cashed-in the policies. The life insurance company sent Forms 1099, which the Fuglers did not report on their joint tax return.

COMMENT: As we have discussed before, the IRS loves to trace Forms 1099 to tax returns, as the process can be computerized and requires no IRS manpower. You, on the other hand, have no such luck and will likely contact your tax preparer/advisor – and incur a fee - to make sense of the notice. There you have current tax administration in a nutshell: increasingly shift compliance to taxpayers by requiring almost everything to be reported on a 1099. It is a brilliant if not cynical way to increase taxes without – you know – actually increasing taxes.

Here is a recap of the relevant Fugler numbers:      

		Policy #1		Policy #2
Cumulative premiums paid		6,850		6,850
Accumulated cash value		22,878		23,428
Outstanding loan & interest		(19,845)		(20,699)
Settlement check		3,033		2,729

 

On first impression, it might seem odd that the Fuglers did not report the two distribution checks: the $3,033 and the $2,729. This is the amount they received upon policy cancelation – and after repaying policy loans and related interest and whatnot charges. Then again, one does not normally expect to have taxable income from life insurance. One should still report the 1099 amount (so the IRS computers have something to latch onto) and thereafter adjust the numbers to what one considers correct. Without that latch, these IRS matching notices are automatic.

So, what do you think:

·      Do the Fuglers have income?

·      If so, what is the income amount?

To reason through this, think of the life insurance policies as savings accounts. Granted, inefficient savings accounts, but the tax reasoning is similar. If you put in $6,850 and years later receive $22,878, the difference is likely (some type of) income. The same reasoning applies to the second policy.

So, you have income. Is there some way to not have income? Sure, if the cumulative premiums you paid exceed any cash value. In that case any refund would be a return of your own money.

But what is the income amount: is it the checks they received: $3,033 (for policy #1) and $2,729 (for policy #2)?

Normally, this would be correct, but the Fuglers borrowed against the polices. The loan did not create income at the time (because of the obligation to repay). That obligation has now been repaid with cash that would otherwise have been included in those distribution checks. You cannot avoid income by having a check go directly to your lender. Tax advisors would have a field day if only that were possible.

I would say that the income amount is the cash received plus the loan forgiven: $16,028 (policy #1) and $16,578 (policy #2).

Before thinking the result unfair, remember that the Fuglers did receive the underlying cash. The timing for the taxation of the loan was delayed, but even that result was pro-taxpayer. This is not phantom income that we sometimes see in other areas of the Code.

There is some chop in the numbers for the loan forgiven. As you can imagine, there are all kinds of fees and charges in there, as well as possibly accrued interest on the loan.  The Fuglers thought of that also, arguing that the accrued interest should not be taxable – or at least should be deductible.

The “should not be taxable” is a losing argument, as all income is taxable unless the Code says otherwise. It does not, in this case.

That leaves a possible interest deduction.

The problem here is that Congress limited the type of nonbusiness loans whose interest is deductible: loans on a principal residence; loans used to buy or carry investments, college loans; loans (starting in 2026) on a new car with final assembly in the United States. Any other nonbusiness loans are considered personal, meaning the interest thereon is also personal and thus nondeductible.

The Fuglers could not fit into any of those deductible categories. There was no subtraction for interest, no matter what the insurance company called it.

The Fuglers had taxable income. They reported none of it on their return. The IRS – as usual – wanted interest and penalties and whatever else they could get.

The Tax Court agreed.

Our case this time was Fugler v Commissioner, T.C. Summary Opinion 2025-10.

Penalties For Cash Reporting Failures

 

It would be a vast understatement to say that the plucky Rebellion had software issues this busy season.

We saw (some of) it coming … given the merger and all. Short of Excel and Word, there was little overlap between our softwares - that is, our preparation software, research software, time reporting, invoicing and receipt, monitoring the accounting practice and whatnot.

We are still working through the shock.

And I see a Tax Cout decision issued about a week ago concerning software.

I can tell you before reading it how the Court will decide:

Software – unless involving matters exceeding the minds of mortal men – will not save one from penalties. If one purchases and installs software, one is under obligation to learn and master it.

My thoughts?

I am divided. An ordinary taxpayer does not – should not - need my services. Reach a certain point though, and a tax professional becomes as necessary as a primary physician or a dentist.

Still, the Code has become increasingly complex since I came out of school. The very computerization that has allowed professionals to streamline and systematize their work has simultaneously allowed the Congressional tax committees to draft and score increasing complex and near-unworkable changes to the Code. Far too many of these changes can potentially reach ordinary taxpayers. That taxpayer would probably not know that he/she wandered into a minefield. He/she would learn of it when the penalty notice arrived, however. The IRS (and too often the courts) presume that you have a graduate degree in taxation – ignorance of the law is no excuse and all that flourish. They do not care that you don’t.

Dealers Auto Auction of Southwest LLC (Dealers) was an Arizona company selling vehicles through auction houses. It frequently received cash in the ordinary conduct of its business. Not surprisingly, the cash from a sale would often exceed $10,000.

There is a Code section involved here:

          Section 6050I

(a)  Cash receipts of more than $10,000

Any person

(1)  Who is engaged in a trade or business, and

(2)  Who in the course of such trade or business, receives more than $10,000 in cash in 1 transaction (or 2 or more related transactions),

shall make the return described in subsection (b) with respect to such transaction (or related transactions) at such time as the Secretary may by Regulations prescribe.

Once Sec 6050I is triggered, the company files Form 8300 with the IRS. It is an information return (no taxes go with it), but there are penalties for failure to file the return.

Not surprisingly, it has its own rules and subrules.

You know the Forms 8300 were an issue for Dealers.

They bought software (AuctionMaster) to deal with it.

They bought the software after flubbing the 2014 Form 8300 filings. The IRS assessed penalties of over $21 grand, and Dealers realized that buying software was cheaper than paying penalties.

And … the IRS was back in 2016.

Why?

Dealers filed 116 Forms 8300. The IRS argued that Dealers should have filed 382.

The IRS wanted over $118 grand in penalties.

Yipes!

Here is the Court:

Dealers Auto was not immediately aware of its failures. Instead, it was not until the Commissioner began the examination that Dealers Auto became aware of its noncompliance.”

Dealers was blindsided.

It took immediate steps:

·       It contacted the software provider and learned that improved aggregation features were available starting in 2017 (the year following the audit year).

·       Dealers quizzed the auditor on the subtleties of Form 8300 and its filing requirements.

·       Dealers changed its procedures and internal control for filing 8300s.

·       Dealers changed to electronic filing of the 8300s. They let the software cook.

No way the IRS was going to retract that $118 grand-plus assessment, though.

Dealers appealed the penalty. It wanted abatement for reasonable cause.

COMMENT: So would I, frankly.

Dealers’ argument was straightforward: we relied on software, and the software malfunction was outside of our control.

The IRS responded: there was no malfunction. You never mastered the software. If you had, you would have realized that it was not functioning as you thought.

Harsh, methinks. Probably honest, though.

Here is the Court:

Dealers Auto failed to establish that there was a software failure.”

The instructions for the software suggest that the software prepared Forms 8300 for printing, but Dealers Auto asserts that the software files the forms on the user’s behalf.”

Even assuming Dealers Auto met its burden to show a failure beyond the filer’s control, the record does not support a finding that Dealers Auto acted reasonably before or after the failure. For example, Dealers Auto did not establish that it was correctly using the software or that data was being entered correctly into the system.”

Dealers Auto argues that it reasonably believed the software was working as intended because it was generating some information returns. But the record shows that Dealers Auto software prepared only 116 Forms 8300 in 2016. The record also shows that Dealers Auto was required to file at least 212 Forms 8300 in 2014.”

This is going poorly.

What do I see?

I see a small business that was surprised in 2014. It responded with technology, but its familiarity with technology appears limited. It got surprised again. Normally that would indicate recidivism, but I don’t think that is what happened here. I think Dealers had only so many resources to throw at a problem. In addition, they may not have realized the extent of the problem if they were quizzing the IRS auditor on the ins and outs.

What did the Court see?

While it is not necessary to show that Dealers Auto made every data entry correctly, the record offers the Court no insight as to Dealer Auto’s installation, training, or use of the software.”

Here it comes:

Dealers Auto failed to establish that it has reasonable cause for its failure to file information returns for 2016.”

What disappoints me about cases like this is the failure to reward a taxpayer’s effort. Dealers tried. It bought software. It was filing, albeit not as much as it was supposed to. Should it have expended more money and resources on the matter? Clearly, but then I should have played in the NFL and retired as a Hall of Famer. The IRS is punishing Dealers like a scofflaw who did not care, made things up and never intended to follow the rules. To me, applying the same penalties to both situations is abusive.

Our case this time was Dealers Auto Auction of Southwest LLC v Commissioner, T.C. Memo 2025-38.

The IRS Goes Rounds With Cohan

 

The decision begins with the IRS seeking taxes of $805,149, $1,145,104, $1,161,864, and $831,771 for years 2013 through 2016. The penalties were unsurprisingly also enormous.

I want to know what happened here.

The taxpayer was Mohammad Nasser Aboui, and he was the sole shareholder of an S corporation called HPPO. He owned several used vehicle lots, and in 2009 he put them into HPPO as its initial corporate capitalization.

It sounds like a tough business:

·       Most of HPPO customers had bad credit.

·       Many did not have a checking account and instead paid HPPO in cash.

·       HPPO financed between 90% and 95% of its sales.

·       Customers repaid their loans less than 10% of the time.

·       HPPO repossessed approximately 25% of the cars it sold within 3 or 4 months.

·       HPPO had quite the barter system going with its mechanics: the mechanic would work on HPPO cars in exchange for rent of HPPO’s garage space.

Around 2014 Aboui decided to close the business. There were serious family health issues and HPPO was not making any money.

The IRS started its audit in September 2015.

HPPO’s accountant was ill at the time and later died.

To its credit, the IRS waited.

More than 3 years later HPPO engaged another accountant to represent the audit.

The second accountant made immediate mistakes, such as getting HPPO’s accounting method wrong when dealing with the IRS Revenue Agent (RA).

COMMENT: More specifically, the accountant told the RA that HPPO used the overall cash basis of accounting. HPPO did not. In fact, it could not because inventory was a material income-producing factor.

The RA wanted HPPO’s books and records, including access to its accounting software. HPPO could provide much but not the software. Its software license expired when it left the vehicle business in 2018.

This is a nightmare.

HPPO did eventually reactivate the software, but it was too late to help with the RA.

The RA – being told by the second accountant that HPPO used the cash basis of accounting – decided to use bank statements to reconstruct gross income.

BTW HPPO wound up dismissing the second accountant.

The results were odd: HPPO had reported more sales for 2013 through 2015 – nearly $3.25 million - than was deposited at the bank.

The pattern reversed in 2016 when HPPO deposited approximately $539 grand more than it reported in sales.

COMMENT: I have an idea what happened.

The RA also saw following bad debt expense:

          2013             $1,069,739

          2014             $ 668,537

          2015             $ 902,967

          2016             $ 436,738    

Here is something about the cash basis of accounting: you cannot have bad debt expense. It makes sense when you remember that gross income is reported as monies are deposited. Bad debts are receivables that are never collected, meaning there is nothing to deposit. One never leaves home plate.

So, the RA disallowed the bad debt expense entirely.

I am pretty sure about my earlier hunch.

The RA also determined that HPPO had distributed the following monies to Aboui, one way or another:

          2013             $2,476,301

          2014             $1,704,329

          2015             $1,406,893

2016             $1,934,033

There were other issues too.

Off they went to Tax Court.

Remember what I said about reactivating the accounting software license? Aboui now presented thousands of pages to document cost of sales and other expenses. The Court encouraged the IRS to accept and review the new records.

The IRS said, “nah, we’re good.”

COMMENT: Strike one.

The Court started its opinion with HPPO’s sales.

The RA stated to the Court that HPPO used the overall cash basis of accounting.

Don’t think so, said the Court. The Court saw HPPO using the accrual basis of accounting for sales and the cash basis of accounting for everything else.

COMMENT: This is referred to as a hybrid method: a pinch of this, a sprinkle of that. If one is consistent – and the results are not misleading – a hybrid is an acceptable method of accounting.

The Court asked Treasury why it thought that HPPO used the cash basis of accounting.

Treasury replied that it had never said that.

The Court pointed out that the RA had said that she understood HPPO to be a cash basis taxpayer. To be fair, that is what the second accountant had told her.

Nope, never used the cash method insisted Treasury.

COMMENT: An explanation is in order here. Treasury Department attorneys take over when the matter goes to Court. Perhaps the attorneys meant “direct” Treasury. The RA – while working for the IRS which itself is part of the Treasury – would then be “indirect” Treasury. I am only speculating, as this unforced error makes no sense. Clearly it bothered the Court.

Strike two.

The Court then reasoned why HPPO was reporting more sales than it deposited in the bank: it was reporting the total vehicle sale price in revenues at the time of sale. That also explained the bad debt expense: HPPO financed most of its sales and most of those loans went sour.

But why the reversal in 2016?

Aboui explained to the Court that by 2016 he was closing the vehicle business. He would have slowed and eventually stopped selling cars, with the result that he would be depositing more in the bank than he currently sold.

The Court decided that HPPO had correctly recorded its sales for the years at issue.

Next came the cost of vehicles sold.

This accounting was complicated because so much cash was running through the business. Sometimes cash was used to immediately pay expenses without first being deposited into a bank account – NOT a recommended accounting practice.

The RA had also identified certain debits to HPPO’s bank account that were either distributions or otherwise nondeductible.

The Court could find no evidence that those identified debits had been deducted on the tax returns.

The RA – and by extension, the … Treasury – was losing credibility.

Aboui meanwhile provided extensive documentation of HPPO’s expenses at trial. Some of these were records the Court had asked the IRS to accept and review – and which the IRS passed on.

Here is the Court:

Petitioners provided extensive documentation at trial to substantiate the COGS and business expenses. Mr. Aboui testified that HPPO was unprofitable. Given the record in its entirety, we find that petitioners have substantiated HPPO’s COGS and business expenses as reported on HPPO’s returns for each year at issue, except for meal and entertainment expenses of …..”

COMMENT: Strike three.

The Court went to the bad debts.

Mr. Aboui credibly testified that he was unable to repossess approximately 250 cars during the years at issue. The loss of these cars adequately substantiates the amount of HPPO’s bad debt deductions for the years at issue under the Cohan rule.”

The Court went to the distributions.

Respondent determined that petitioners failed to report approximately $7.5 million in taxable distributions from HPPO during the years at issue.”

COMMENT: Remember that HPPO is an S corporation, and Aboui would be able to withdraw his invested capital – plus any business income he had paid taxes on personally but left in the business – without further tax. This amount is Aboui’s “basis” in his S corporation stock.

Here is the Court:

Respondent argues that petitioners have not established Mr. Aboui’s basis in HPPO during the years at issue. We disagree and that the record and Mr. Aboui’s credible testimony provides sufficient evidence for us to reasonably estimate his basis under the Cohan rule.”

The IRS won a partial victory with the distributions. The Court thought Aboui’s basis in HPPO was approximately $5.1 million.

The IRS had wanted zero basis.

The effect was to reduce the excess distributions to $$2.4 million ($7.5 minus $5.1).

Still, it was a rare win for the IRS.

Excess distributions are taxable. Aboui had taxable distributions of $2.4 million. Yes, it is a lot, but it is also a lot less than the IRS wanted.

COMMENT: The nerd part of me wonders how the Court arrived at an estimate of $5.1 million for Aboui’s basis. Unfortunately, there is no further explanation on this point.

Oh, one more thing from the Court:

… we hold that petitioners are not liable for any penalties.”

While not contained within the four corners of this decision, I am curious why the Court repetitively went to the Cohan rule. I have followed this literature for years, and this result is not normal. Courts generally expect a business to maintain an accounting system that produces reliable numbers. Yes, every now and then there may be a leak in the numbers, and the court may use Cohan to plug said leak. That is not what we have here, though. This boat was sinking.

Perhaps Aboui presented his case well.

Mr. Aboui was incredibly forthright in his testimony.”

And perhaps the IRS should not have argued that an RA – an IRS employee – is not the IRS.

Our case this time was Aboui and Mizani v Commissioner, T.C. Memo 2024-106.